Marginal Cost of Capital

The marginal cost of capital (MCC) is the cost of obtaining additional funds for a company’s operations. It is the cost of the last dollar of financing raised and is an important factor in determining whether a company should undertake a new project or investment. The MCC is influenced by a variety of factors, including market conditions, the company’s capital structure, and the risk associated with the project or investment.

Calculation of MCC:

The calculation of MCC involves determining the cost of each additional dollar of financing raised. This can be done by calculating the cost of each individual source of financing, such as debt or equity, and then taking the weighted average of these costs. The formula for calculating MCC is as follows:

MCC = (change in total cost of capital) / (Change in total capital raised)

Where:

Change in total cost of capital = (change in cost of equity x weight of equity) + (change in cost of debt x weight of debt)

Change in total capital raised = (change in equity capital) + (change in debt capital)

The weights used in the formula are based on the proportion of each source of financing in the company’s capital structure.

Factors affecting MCC:

• Market conditions: Market conditions, such as interest rates and the availability of financing, can significantly impact the MCC. Higher interest rates and limited availability of financing can increase the cost of capital, while lower interest rates and readily available financing can decrease the cost of capital.
• Capital structure: The company’s capital structure can also influence the MCC. Companies with a high proportion of debt in their capital structure may have a higher MCC due to the higher risk associated with debt financing. Conversely, companies with a high proportion of equity in their capital structure may have a lower MCC due to the lower risk associated with equity financing.
• Project or investment risk: The risk associated with a specific project or investment can also impact the MCC. Projects or investments with higher risk may require a higher return on investment, which can increase the cost of capital.

Advantages of MCC:

• Useful in decision-making: The MCC is a useful metric for companies to determine whether a new project or investment is financially feasible. It helps companies evaluate the cost of obtaining additional financing and whether the return on investment is sufficient to cover the cost of capital.
• Considers incremental costs: The MCC considers the incremental cost of obtaining additional financing, which provides a more accurate estimate of the true cost of capital.
• Helps optimize capital structure: The MCC can also help companies optimize their capital structure by determining the most cost-effective mix of debt and equity financing.
• Helps manage risk: The MCC can also help companies manage risk by providing insight into the risk associated with specific projects or investments.

Limitations of MCC:

• Assumes linear relationship: The MCC assumes a linear relationship between the change in total cost of capital and the change in total capital raised, which may not always be accurate in practice.
• Sensitive to input assumptions: The MCC is sensitive to input assumptions, such as the cost of debt and equity, which can vary depending on the method used to calculate them.
• Does not consider other factors: The MCC does not consider other factors that may affect a company’s cost of capital, such as market risk and company-specific risk.
• Ignores financing constraints: The MCC assumes that financing is readily available, which may not always be the case. Companies may face financing constraints that limit their ability to obtain additional financing at a reasonable cost.

Question:

Assume that a company has the following capital structure:

Equity: 60%

Debt: 40%

The company’s current cost of equity is 12% and the cost of debt is 6%. The company is considering a new project that requires an investment of $500,000. The company expects to finance the project with a mix of debt and equity. The cost of equity is expected to increase to 13%, while the cost of debt will remain the same. Determine the marginal cost of capital for the project.

Weights of capital structure:

Cost of capital:

Expected cost of capital:

Answer:

To calculate the marginal cost of capital, we need to determine the change in total cost of capital and the change in total capital raised:

Change in total cost of capital = (13% – 12%) x 60% + (6% – 6%) x 40% = 0.6%

Change in total capital raised = $500,000

Marginal cost of capital = (0.6% / $500,000) x 100% = 0.12%

Therefore, the marginal cost of capital for the new project is 0.12%. This means that the company will need to generate a return on investment of at least 0.12% higher than the cost of capital to create value for its shareholders.

Differences between Weighted Average Cost of Capital (WACC) and Marginal Cost of Capital